NLRB Ruling on McDonald’s Puts Franchising Stocks in Jeopardy

As if McDonald’s (MCD[1]) wasn’t experiencing enough growth problems, a key government agency has made it even less compelling for the company to expand its footprint.

The National Labor Relations Board — an independent federal agency with the power to prevent and remedy unfair labor practices committed by private sector employers — has determined that the parent company can be held accountable for the labor practices of McDonald’s franchisees. The ruling effectively eliminates at least one of the key reasons the company would choose to franchise itself rather than own its own restaurants, which is to circumvent the inherent (and occasionally costly) headache of directly employing 1.7 million people scattered all across the globe[2].

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Source: Flickr[4]

Although the announcement from the NLRB was specific to McDonald’s, now that the precedent has materialized, it wouldn’t be a stretch to assume the government agency will feel the same about other organizations and industries that depend on the franchising business model. Specifically, the ruling raises the inherent risk of restaurant stocks, some hotel stocks, and even some retailing stocks.

What the National Labor Relations Board Said

Just for the sake of clarity, this is the bulk of Tuesday’s official statement from the National Labor Relations Board[5]:

“The National Labor Relations Board Office of the General Counsel has investigated charges alleging McDonald’s franchisees and their franchisor, McDonald’s, USA, LLC, violated the rights of employees as a result of activities surrounding employee protests…The Office of the General Counsel has authorized complaints on alleged violations of the National Labor Relations Act. If the parties cannot reach settlement in these cases, complaints will issue and McDonald’s, USA, LLC will be named as a joint employer respondent.”

The decision is in contradiction to long-established franchising relationships, most of which allow an independent contractor to use a brand name, purchase proprietary goods and supplies, and even benefit from corporate-level advertising, all in exchange for an upfront and/or annual franchise fee. At the core of the contractual relationship, however, was a franchisee’s acceptance of the business risk — one of the biggest of which was the inherent risk of hiring employees — in exchange for the bulk of any financial success a particular restaurant may generate.

The NLRB effectively destroys that employee-risk firewall, putting McDonald’s in the same hot-seat with franchisees, even though the corporation itself had and has no say in the hiring and employment of most of the chain’s workers. The argument in favor of such a decision is the notion that McDonald’s keeps such tight control over nearly every aspect of its franchisee’s business that it’s impossible to say the corporation isn’t culpable for how employees are treated or paid.

So, what does this mean for other franchise-heavy businesses?

As was noted, with the first chain being officially named as a target, it becomes much easier for the National Labor Relations Board to put other franchises on its legal hit-list. And, there are plenty in a variety of industries from coast to coast, some of which may surprise you. For instance…

McDonald’s: Of the 14,000 golden arches in the United States, 90% are franchises[6].

Subway: It’s not a publicly-traded company, but it’s still a huge franchiser. In fact, it’s the nation’s most popular franchise opportunity. Nearly 27,000 of its 42,241 stores are located in the U.S., and every single one of them is a franchise[7].

Hilton Hotels and Resorts (HLT[8]): Yes, believe it or not, many of the well-known hotel chain’s locations are actually franchised. In fact, on a global basis, most of them — 444 in all — are franchised on a global basis[9], versus only 114 Hilton hotels being company-owned.

GNC Holdings (GNC[10]): Yes, America’s most prolific nutrition and supplement store also relies on franchisees to drive a big chunk of its sales. Of the 6400 units found in the United States, 1,026 of them are franchises[11]. Another 2,223 of the shops found in Rite-Aids also qualify as franchises.

While restaurant stocks may be feeling a little more pressure now, the risk has been heightened just as much for some retailing stocks and even a few hotel stocks (or at least parent companies or private equity funds that own these chains). Indeed, labor-intensive hotel franchises may be more vulnerable to the National Labor Relations Board’s recent ruling than the restaurant industry is.

The Impact of the NLRB Ruling on Franchising

As Newton’s third law of motion explains it, for every action, there’s an equal and opposite reaction. At stake for all of these franchisers is a much tougher — perhaps even debilitating — labor environment.

Given the much-publicized traction that enough McDonald’s employees have gained with the NLRB, workers at other restaurants, hotels, service providers and retailers could new feel empowered enough to begin rattling their own cages. That’s not to say these groups of employees don’t have a right to organize and/or report broken laws, but it does put the franchisers in a tricky situation … more of the risk of being an employer, but no additional revenue or income for taking on that risk.

The end result can only be higher franchise fees, stricter standards when making franchising decisions, or both. Eventually, it’s the consumer that will end up footing the bill, either through higher prices or fewer restaurant and hotel choices, or a combination of both.

Bottom Line for the Franchise Model

It’s too soon (and unnecessary) to write off the franchise business model, and none of this is to say restaurant stocks and hotel stocks that rely on franchising are headed for their complete and utter demise. This is going to be another looming liability that becomes part of the normal course of business though, and like all liabilities, it will eventually chip away at balance sheets and income statements. It’s something investors at least need to keep in mind.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Endnotes:

MCD: /stock-quotes/MCD-stock-quote/

employing 1.7 million people scattered all across the globe: http://mail.sourcewatch.org/index.php/McDonald%27s